Over leveraging: the reason traders fail

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03 Jul 2023

Why are so many people eager to trade with prop firms? It’s simple! With funded accounts, you get a safe leverage ratio to both protect yourself from losses and amplify gains.

However, what is leverage? While everyone has heard about leverage, novice traders hardly know what it is. In short, it’s the ability to use borrowed funds to gain a greater position in the market beyond the available one from your account balance. It allows traders to amplify potential returns and trading power.

What is over leveraging in trading? It occurs when a trader uses more leverage than they can afford. Although leverage can amplify gains, you should keep in mind it can amplify losses as well. So, when it comes to over-leverages, the risk of losing all invested funds is very high.

The pitfalls of over-leveraging

If you’re not aware of how to use leverage in trading, consider the pros and cons first. While such benefits as increased trading power, enhanced profit potential, and diversification opportunities serve to generate higher profits compared to trading with your own funds, it‘s worth remembering the cons.

They include, but aren’t limited to increased losses, higher risk of capital depletion, and market volatility. There is always the risk of adverse price movement that can lead to losses that exceed the initial investment in leaps and bounds, and result in financial damage.

Over leveraging is the main reason why many Forex traders fail. By acting that way, they risk a lot. Their account balance can be wiped in mere minutes.

Here are the pitfalls of over-leveraging:

1. Significant risk of huge losses

First off, over-leveraging increases the risk of losing money. By using leverage, traders just borrow funds to place larger trades. If the trade goes against them, they can lose all invested funds and even trading accounts.

Keep in mind that if you can’t create great returns at low leverage, you won’t do so on high leverage as well. But for sure, you can expect massive losses instead.

2. Excessive emotionality

When traders lose big, they may outburst and make irrational trading decisions. Such behavior leads to further losses. In most cases, chasing losses leads to even bigger losses.

The best traders are those that can put their emotions at bay during the trading activity. At that time, the heart should beat calmly while the brain should be in charge.

3. Transaction costs can eat your profit

Not only does leverage increase your losses but also amplifies your transaction costs. Over-leveraging leads to higher trading costs and you can do nothing with higher fees and interest charges you should pay. Don’t you think that could reduce profits significantly?

As a trader, you must consider the associated cost of using high leverage. With time, it may impact your account: the higher the leverage, the higher the transaction cost as it is a percentage of your trading capital.

At FXCI, we believe that our clients understand the impact of over leveraging on a profitable trade. We never tire of repeating that allowing excessive leverage is in the interests of neither our clients nor our firm.

4. The danger of margin calls

Margins help traders to prevent potential losses. A margin call may appear when the market moves against the trader and the losses exceed the available limit. It requires the trader to deposit more funds to maintain the current position. Otherwise, the trades may be closed. Usually, such a margin closeout leads to significant losses.

What to do to avoid high leverage?

Most trading platforms establish a responsible trading program that provides safety measures, such as leverage limits, anti-addiction limitations, “cooling-off” suspension features, and so on.

But no program can predict the trader’s behavior in any given situation. To avoid over leveraging, traders need to know the dangers of trading and use proper risk management strategies. It goes without saying that poor risk management is one of the most common reasons why traders lose funded accounts.

We can provide you with some tips on how to avoid over-leveraging:

1. Find the perfect leverage ratio

The leverage ratio is the proportion between the trader’s capital provided by the prop firm and the total position size. Leverage ratios are of the essence as they indicate the level of trading power, potential profits, and risks a trader can undertake.

Using leverage allows traders to control larger positions with smaller capital investments and thus maximizing their trading power and potential returns. Those of you scalping and day trading with short-term trading strategies may benefit from higher leverage to take advantage of small price movements and generate quick profits. Finally, we should mention high-conviction trades. This is when you have a strong conviction about a trade setup or market opportunity. In such cases, leverage can improve overall profitability and boost potential gains.

To minimize risks, traders should use a low leverage ratio. A leverage ratio of 1:10 or 1:20 is considered safe, and it can help traders avoid unnecessary losses, but their gains would be smaller consequently.

What is a happy medium between high and low leverage, you might ask? By joining a prop trading firm FXCI you can get leverage of 1:100. This is the perfect spot for traders who have valid strategies and the discipline to manage losses.

2. The balance between leverage and effective risk management

There is a necessity to consistently monitor your trades, account balance, and market conditions. The general idea is to keep the balance between utilizing high leverage and the associated risks. So, it’s crucial to stick to discipline, follow a trading plan, and adapt risk management strategies to volatile market conditions. Some effective techniques help maintain control:

  • A stop-loss order plays a crucial role in risk management. Implementing it is vital. It’s developed to help traders limit their losses. Traders must always set stop-loss orders to protect their capital and minimize their risks. After all, they close a trade automatically if the market moves against you;
  • Proper position sizing based on risk tolerance and account size is crucial;
  • Diversification is designed to balance potential losses and profits;
  • Your trading plan should outline your objectives, entry and exit strategies, risk tolerance, and risk management rules. Stick to your plan unconditionally. It helps to avoid the rush or emotional trading decisions;
  • Always maintain emotional discipline. It is essential for managing effective margin and leverage in Forex trading.

3. Learn the “Speculator's Guilt” lesson and don’t repeat it

The level of risk in the transactions is the main difference between investing and speculating. Whenever a trader spends money expecting that the deal will be profitable, they are investing. In this case, the risk is based on a reasonable judgment made after thorough research that the trade has a good chance of success.

But what if the same trader spends money on a deal with a high probability of failure? In this case, they are speculating.

As success or failure depends primarily on chance, there is no winner in financial trading. The more people stress over 'the investment to make', the more you should be alert. Never bet it, ever. Even if you‘re sure you can rebuild it all again, others may not hang around and wait. You can lose much more than money by risking it all with the Speculator's Guilt.

Conclusion

Forex traders should have a good understanding of leverage and its consequences. As we said above, leverage can increase both profits and losses. Therefore, it makes perfect sense to know how to balance leverage and effective risk management. Not only will it let you navigate the Forex market with greater control, but also minimize the potential impact of volatile price movements.

In this regard, it’s worth mentioning that nothing related to the Forex market is dangerous. Forex is perhaps the safest of the markets. In general, the prices float very slowly there, and the wipe-out of an unleveraged account is almost impossible. But simply because many people think they can get rich there quickly, they use abnormal levels of leverage for this purpose. Therefore, they rather fail there than succeed. But not you!

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